What is a network effect?

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A network effect refers to a significant change in a product/service value due to increased usage. Network effects play a significant role in the cryptocurrency ecosystem. For example, if new users join a particular blockchain network in large numbers, the underlying service likely offers more utility.

What is a network effect?

A network effect refers to an economic effect where an increase in the number of users of a product or service adds more value to the network. In the presence of a network effect, new users entering the network are incentivized, thereby adding more value to an underlying product or service.

With an increase in the number of users, the value of the entire network increase accordingly. The telephone network is a classic example of a network effect where increased usage led to more affordability, thereby increasing the value of the entire telephone network. Different factors determine which cryptocurrency projects lead the market in a particular sector. A promising or innovative technology alone may not determine the relevancy or popularity among its users.

There have been numerous instances where technologically inferior projects managed to secure a significant market share. What matters more to users is the availability of a project at a particular time. This is essentially where network effects play an essential role.

Types of network effects

There are two main types of network effects:

  1. Direct network effects
  2. Indirect network effects.

A direct network effect is more straightforward where increased usage adds value for all other users — for example, the telephone network. With an indirect network effect, increased usage from one set of users adds value for another set of users. Since many cryptocurrency projects are open-source, developers tend to audit the underlying code due to a strong network effect.

This additional increased usage results from an existing network effect, which determines which cryptocurrency projects become the market leader in a specific sector.

Network effects and cryptocurrencies

In blockchain and cryptocurrency, network effects are an essential factor to consider. For example, Bitcoin has a strong network effect with characteristics that attract most users. Consider that BTC miners uphold the network’s security without worrying about liquidity. Even if another, technologically more superior project emerges out of the blue, serving a similar use case as Bitcoin, switching to it wouldn’t necessarily be ideal.

Sure, miners may earn significantly higher rewards but won’t necessarily enjoy the same liquidity as BTC. In the case of Bitcoin, in particular, the unique features and characteristics of BTC are challenging to replicate, making users stick to it in the long term.

Although network effects could play an important role in the Decentralized Finance (DeFi) space, no smart contract projects have arguably achieved a strong network effect so far that makes them a market leader.

Negative network effects

Negative network effects are when new users entering the network subtract value from the network. Ethereum gas fees are one example of a negative network effect. With an increase in the number of users bidding on gas fees to be paid for Ethereum miners, Ethereum gas fees increase.

Conclusion

Much like different economy segments, network effects also impact the value of cryptocurrencies, where new users add value to the network. By taking network effects into account while designing blockchain networks, developers can pave the way for faster scalability.